A market maker is quoting a $0.05 spread on a large-cap stock. News breaks that the company's CEO has just resigned unexpectedly. The market maker cannot yet tell whether incoming orders are from informed traders reacting to the news or uninformed traders. What should the market maker do immediately?
ANarrow the spread to attract more order flow and recover losses through higher volume
BWiden the spread or withdraw quotes entirely, because adverse selection risk has spiked
CMaintain the current spread since the CEO resignation is already public information
DOnly trade with institutional investors until the informed/uninformed ratio normalizes
When major news breaks, adverse selection risk spikes immediately — the probability that an incoming order is from an informed trader jumps dramatically. Since the market maker cannot distinguish informed from uninformed traders, they must widen the spread to protect against informed order flow, or pull quotes until price discovery stabilizes. Narrowing the spread would be self-destructive: more volume at a narrow spread means more losses to traders who now know more than the market maker. This is why spreads widen sharply during news events.
Question 2 Multiple Choice
During the March 2020 COVID market stress, spreads on many normally liquid instruments widened by 5–10× within days. The best explanation is:
ATrading volume fell, so market makers needed to earn more per trade to cover fixed costs
BRegulators required wider spreads to slow panic selling
CVolatility, uncertainty about fundamentals, and reduced dealer capital all spiked simultaneously, driving up all three components of the spread
DHigh-frequency traders withdrew, leaving only slower market makers who require wider spreads
Liquidity crises occur when all three spread components spike at once. Volatility increased inventory risk dramatically. Uncertainty about fundamental values increased adverse selection. Dealer capital contracted as firms faced margin calls and restricted risk. Each force alone widens spreads; all three together produced a liquidity spiral: wider spreads force leveraged investors to sell; forced selling moves prices; larger price moves increase volatility; increased volatility widens spreads further. The dynamic feeds on itself rather than declining gradually.
Question 3 True / False
At the optimal bid-ask spread in a competitive market, a market maker earns zero profit from trades with informed traders and positive profit from trades with uninformed traders.
TTrue
FFalse
Answer: False
At the optimal spread, the market maker earns *negative* profit from informed traders (they lose money on every trade with someone who has superior information) and *positive* profit from uninformed traders. The equilibrium spread is set so that profits from uninformed trades exactly cover losses from informed trades, yielding approximately zero economic profit overall in a competitive market. The spread is not set to earn zero from informed traders — that would require being able to identify and screen them, which the market maker by assumption cannot do.
Question 4 True / False
In a perfectly competitive market with many market makers, bid-ask spreads will converge to zero because competitive pressure eliminates most transaction costs.
TTrue
FFalse
Answer: False
Competitive pressure reduces spreads but cannot eliminate them entirely, because all three cost components remain positive in any real market. Order processing requires real resources; inventory must be financed and carries market risk; and as long as some traders have private information, adverse selection exists. In extremely liquid markets (large-cap equities, on-the-run Treasuries), spreads are very narrow but never reach zero because the underlying economic costs are minimized, not eliminated. Spreads would only converge to zero in a world with no information asymmetry, no inventory risk, and zero operational costs.
Question 5 Short Answer
Explain why adverse selection is considered the most economically interesting component of the bid-ask spread. What is the fundamental problem it creates for market makers?
Think about your answer, then reveal below.
Model answer: Adverse selection arises because some traders possess private information the market maker does not — about upcoming earnings, pending mergers, or fundamental value. The market maker cannot identify which traders are informed before dealing, so every trade carries some probability that the counterparty knows more. Informed traders buy just before a price increase or sell just before a decrease, leaving the market maker holding a position that immediately moves against them. To survive, the market maker sets spreads wide enough that profits from the uninformed majority cover these losses. The fundamental problem is asymmetric information combined with the inability to screen counterparties.
Order processing costs are predictable and manageable; inventory risk can be partially hedged. But adverse selection is intrinsic to the information structure of markets — it exists whenever some traders have access to information others lack, and it cannot be engineered away without destroying market anonymity. This is why information asymmetry (a prerequisite topic) is so central to market microstructure: it directly determines one of the three spread components that all participants pay. Disclosure requirements and price transparency genuinely reduce the adverse selection component and thereby improve liquidity.